Macroeconomics Models



There are two approaches to macroeconomic perspectives: classical and Keynesian. The classical model was based on the ideas of Adam Smith, a Scottish philosopher and economist. Classical economists believed markets worked well and adjusted for prices, wages, and interest rates. The Keynesian economics model refers to the various theories of John Maynard Keynes, a British economist. His seminal text, The General Theory of Employment, Interest, and Money, published in 1936, argues that spending (as opposed to saving) is the way to exit an economic downturn, or depression. Many developed countries have adopted this economic philosophy as a means of combating financial instability. Keynes argues that it is the government's responsibility to intervene in times of economic depression, to inject funds into the economy, and help it grow. This argument builds from the idea that during a depression people lose their jobs, and hence, spend less money. A decrease in spending results in businesses achieving less profit. Therefore, as the economic depression deepens, businesses lay off more employees because of shrinking profits. The two main schools of macroeconomic thought have very different perspectives on achieving economic growth in an economy.

At A Glance

  • Macroeconomic models posit that the economy is self-adjusting (classical) or that it is not (Keynesian).
  • The classical theory focuses on long-run economic growth and freely functioning markets.
  • The Keynesian theory focuses on smoothing out short-term fluctuations in the business cycle and reducing or eliminating recessionary and inflationary gaps.
  • The consumption function is an equation that expresses a positive relationship between income and consumption.
  • The marginal propensity to consume is the proportion or percentage of the additional disposable income that a person decides to spend on consumption.
  • The marginal propensity to save is the proportion or percentage of the additional disposable income that a person decides to save.
  • The spending (or expenditure) multiplier is a concept that measures the change in expenditure, which causes a more-than-proportionate change in gross domestic product (GDP). The tax multiplier affects expenditures but at a lower level than spending.
  • The aggregate expenditure model (also known as the Keynesian cross diagram) is a graph that compares the level of aggregate expenditures in an economy with that economy's real GDP.
  • Governments have the ability to regulate their economies by using fiscal policy to affect components of aggregate expenditures that will affect the equilibrium GDP.